The Case of Canadian Business
Although much of the discussion of the economy’s surprising resilience has been (rightly) on the consumer, in this piece we investigate how Canadian businesses are weathering the dual stresses of high inflation and interest rates. On the surface, the macro backdrop looks worrying. The Bank of Canada raised the overnight rate to 5.0% in July and seems poised to keep it there for the foreseeable future, if not raise it further. That has pushed business interest rates to levels last seen in the early 2000s. At the same time, consumers appear to be more sensitive to further price increases as core retail sales have posted back-to-back declines. These two headwinds suggest that profit margins are likely to come under pressure, undercutting a potential driver of future growth, business investment.
A Study in Credit
As interest rates have climbed, the enthusiasm on the part of businesses to take on new debt has soured. Nonmortgage credit growth in Canada has slowed to below 4% on a three-month annualized basis as of June, down from double digits as recently as last fall. That puts it at less than half of its pre-pandemic average (+9.5% between 2015 to 2019) and points to a significant headwind for business investment. Across firm sizes, credit conditions appear to be tightening uniformly according to the latest Business Outlook Survey (BOS) from the Bank of Canada. The percentage of firms reporting tighter versus easing credit conditions in Q2 ranged from 17.3% to 21.5%—levels last seen in 2009. The story is similar in the United States, except credit growth has slowed even more significantly there of late (-3.2% 3-mo ann.). The regional banking stress that came to the fore in March has weighed more heavily on U.S. business lending, as regional banks play an important role—particularly for small businesses and commercial real estate lending. Although recent data have shown a slight improvement, expect credit growth to remain stalled until interest rates begin to decline.
Alongside rising interest rates, business credit quality has come under increasing pressure. Canadian business bankruptcies have climbed significantly since bottoming out during the pandemic and the immediate recovery. The twelve-month total pushed above 3000 in June—the highest in seven years. While higher debt servicing costs are certainly one culprit, the removal of the bulk of the pandemic-era business support programs (e.g., Canada Emergency Wage Subsidy) in the fall of 2021 has also been an important factor in the normalization of business insolvencies. While Canadian bankruptcies are materially above their pre-pandemic level (+17% versus February 2020), U.S. bankruptcies have yet to eclipse the same mark (still 21% below pre-pandemic average). Part of the difference likely comes from the swifter rundown of excess savings on the part of U.S. households, but another factor is the less dramatic drop-off during the height of the pandemic. With consumer spending expected to cool and interest rates likely to remain higher for longer, we anticipate business insolvencies are likely to remain elevated until the Bank of Canada starts to take its foot off the brakes.
The Valley of Fear?
With the deterioration in business credit quality, it’s unsurprising that optimism has waned among firms. The July reading of the CFIB Business Barometer slipped to 55.1, leaving it more than 5 pts below its long-run average, and at levels rarely seen outside of a recession. While that doesn’t bode well for the near-term outlook, the latest Canadian Survey on Business Conditions (CSBC) suggests that there are some important distinctions by firm size underpinning weaker confidence. Micro firms (those with 4 or fewer employees) are the least optimistic for sales over the near term and most pessimistic about declining profitability. Larger firms (5 or more employees) remain more optimistic about near-term sales growth and have significantly upgraded their outlook since the start of the year. Profit margins for those firms are also expected to remain relatively stable despite stiff headwinds. Given that smaller businesses tend to be over-represented in the CFIB confidence measure, the differing performance by firm size likely explains the recent pessimism in the survey.
Faced with stiff competition from large firms over the past few years, small- and medium-sized firms remain more eager to expand payrolls per the latest BOS. Note that the BOC definition of small firms (10 to 99 employees) aligns more closely with the segments of the CSBC that were more optimistic about their near-term performance than the micro firms that appear to be under the most financial pressure. That bodes well for near-term employment in Canada, as firms with between 5 and 499 employees comprise roughly 48% of total enterprise employment.
The Final Problem
The looming deadline (December 31) to repay loans administered through the Canadian Emergency Business Account (CEBA) program remains a key risk to businesses. CEBA allowed businesses to borrow up to $60k interest-free and 33% of the balance is forgiveable if repaid before the end of 2023. Some estimates suggest that as many as 250k businesses could be at risk of going broke if the program isn’t extended. While that sounds like a high figure, in an average year leading into the pandemic, roughly 178k businesses closed their doors permanently (and 189k new firms opened theirs). So if the more dire scenario plays out, it would represent roughly a 40% increase over a typical year, though it would be coming after a stretch from January 2021 to April 2022, when business exits (12-month total) were 6.7% below normal (roughly 190k fewer exits than average). However, it’s clear that micro enterprises, which took out the most CEBA loans (53% of the 898k businesses) will be under the most acute pressure in the months ahead—they are the most pessimistic about near-term sales and profitability and have more limited access to alternative means of finance.
The silver lining for Canadian businesses is that profit margins remain elevated across industries, as a resilient economy is supporting corporate profits. Compared to their 2015-2019 average, profit margins in 2023Q2 for non-financial firms excluding oil, gas and mining were roughly 1 ppt above their 2015-2019 average of 6.4%. While they have fallen from their 2021 peaks (oil and gas and mining profits peaked in 2022), above-average margins have helped firms build up more of a cushion to deal with pressures from rising debt service and input costs. Small businesses tend to be more heavily represented in sectors such as retail trade, recreation, accommodation and food services, and construction. Given that each of those sectors had profit margins above the 75th percentile, there may be some room for those firms to make up ground lost during the pandemic and potentially stem the worst effects from the end of the CEBA program.
Bottom Line: While the music still appears to be playing for Canadian businesses, it has slowed to a waltz. Elevated profit margins will provide a counterbalance to rising borrowing costs, but the looming debt overhang, particularly for micro enterprises, is the last thing that an economy still struggling to incentivize business investment needs.